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Chapter 15 Capital Budgeting

This document discusses capital budgeting, which is the process of identifying, evaluating, planning, and financing capital investment projects. It describes various methods used to evaluate investment projects, including payback period, net present value, profitability index, accounting rate of return, and internal rate of return. It provides examples of how to calculate these measures and whether to accept or reject investment projects based on the required rate of return.

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Celestaire Lee
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89 views16 pages

Chapter 15 Capital Budgeting

This document discusses capital budgeting, which is the process of identifying, evaluating, planning, and financing capital investment projects. It describes various methods used to evaluate investment projects, including payback period, net present value, profitability index, accounting rate of return, and internal rate of return. It provides examples of how to calculate these measures and whether to accept or reject investment projects based on the required rate of return.

Uploaded by

Celestaire Lee
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PPTX, PDF, TXT or read online on Scribd
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CAPITAL BUDGETING

JBCG
INTRODUCTION

• Capital Budgeting is the process of identifying, evaluating,


planning, and financing capital investment projects of an
organization.
• Financing Decision
• Judgment regarding the method of raising capital to fund an
investment.
• Investment Decision
• Judgment about which assets to acquire to achieve the company’s
stated objectives.
Characteristics of Capital Investment
Decisions

• Capital Investment decisions usually require large


commitments of resources.
• Most capital investment decisions involve long-term
commitments.
• Capital investment decisions are more difficult to reverse
than short-term decision.
• Capital investment decisions involve so much risk and
uncertainty.
Commonly Used Methods of Evaluating
Investment Projects

• Payback Period
• Net Present Value
• Profitability Index
• Net Present Value Index
• Accounting Rate of Return
• Internal Rate of Return
Payback Period

• The length of time required by the project to return the


initial cost of investment.
• Investment/Annuity Amount
• Net Cost of Initial Investment/Annual net cash inflows
Net Present Value

• PV of cash inflows – PV of cash outflows


• PV of cash inflows – PV of cost of investment
• PV of cash inflows – Cost of Investment
Profitability Index

• Present Value of net cash inflows/Net investment


PV of Inflows Cost PI NPV

Warehouse $4,200,000 $3,440,000 1.22 $760,000

Distribution 2,360,000 1,700,000 1.39 660,000


Equipment
Net Present Value Index

• Net Present Value/Investment


PV of Inflows Cost PI NPV

Warehouse $4,200,000 $3,440,000 1.22 $760,000

Distribution 2,360,000 1,700,000 1.39 660,000


Equipment
Accounting Rate of Return

• Also called book value rate of return, financial accounting


rate of return, average return on investment and adjusted
rate of return.
• Average annual net income/Average Investment
Internal Rate of Return

• The rate of return which equates the PV of cash inflows to PV of


cash outflows. It is the rate of return where NPV = 0. When the
cash flows are uniform, the IRR can be determined as follows:
1. Determine the present value factor for the IRR with:
PVF for IRR = Net cost of investment/Net cash inflows
2. Using the PV annuity table, find line n(economic life) the PVF
obtained in step 1. The corresponding rate is the IRR. When the
cash flows are not uniform, the IRR is determined using trial-and -
error method.
Sample Problem (page 603)

• Cash Outflows • Cash Inflows


• Year 0 $ 13,500,000 • Electricity cost savings
• Year 1 500,000 • Year 1 $ 2,700,000
• Year 2 300,000 • Year 2 2,900,000
• Year 3 3,200,000
• Year 4 3,900,000
• Year 5 4,200,000
• Year 6 2,100,000
• Year 7 1,000,000
Sample Problem
• JBCG Foundation, Inc., a tax-exempt organization duly registered with
the SEC, is planning to invest P280,000 in a project at the beginning of
2019. The estimated annual cash savings from this project is P90,000.
The project will be depreciated over its 5-year life on a straight-line
basis. The foundations desired rate of return on investments of this
type is 10%
• Info on PV factors is as follows:
@10% @12% @14% @16%
PV of 1 for 5 periods 0.621 0.567 0.519 0.476
PV of an annuity of 1 for 5 periods 3.791 3.605 3.433 3.274
Compute for:
• NPV
a. 61,190 b. 151,106 c. 273,486 d. (550)
• Payback Period
a. 0.321 yearsb. 3.111 yearsc. 5 years d. 1.22 years
• ARR
a. 32.14% b. 12.14% c. 15.18% d. 13.49%
• IRR
a. Less than 10% b. more than 16% c. 10% d. less than 16%
ACCEPT or REJECT?
Sample Problem
• KT Corporation is planning to invest P600,000 in a 5-year project. The
project is expected to produce annual net cash inflows, net of income
taxes, of P150,000. The company’s desired rate of return for
investment projects of this type is 10%.
• Info on PV factors is as follows:

@4% @6% @8% @10%


PV of 1 for 5 periods 0.822 0.747 0.681 0.621
PV of an annuity of 1 for 5 periods 4.452 4.212 3.993 3.791
Sample Questions

• The IRR of this project is:


a. Between 4% and 6%
b. Between 6% and 8%
c. Between 8% and 10%
d. More than 10%
• What is the exact IRR of this investment project?
a. 6% b. 8% c. 7.56% d. 7.94%
CREATING A BETTER
LEARNING EXPERIENCE
JBCG

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